The Basics of Income Taxes

For 100 years, Americans have been paying federal income taxes. In return, the government has defended our freedom, built highways, preserved natural resources and funded programs to help all Americans. During those same years, the income tax law itself and the rules surrounding the law have become huge, complex and confusing. Many have found professional income tax advisors or software programs are essential for preparing tax returns and dealing with all the financial issues associated with income taxes.

This article does not replace the expert advice of professionals, but it rather explains some of the basics so you can better understand how our income tax structure works, how it can affect your financial decisions and how you can be a more-informed income taxpayer.

Our income tax system is generally described as a progressive, marginal rate system. This means as we earn more income, we pay higher rates of tax on that income. To better understand this, consider the following three components—how much is taxed, what tax rates apply and how do we pay the tax. Then, unfortunately, there are all the additional rules.

How Much Is Taxed—or What Is Taxable Income?

Did You Know?

Many people include charitable giving as part of their overall income tax and estate planning strategy.

When you prepare your tax return (Form 1040), or gather information for your tax accountant, you probably start by identifying all your income for the year. This includes your wages (reported on Form W-2 supplied by your employer), dividends and interest (reported on Form 1099 supplied by your bank, credit union, brokerage firm and others), any capital gains you had during the year (determined by your own records or supplied by a mutual fund or brokerage firm) and income from self employment, retirement plan distributions, Social Security income and other sources. You then get reductions for deductible IRA or retirement plan contributions and a couple other items.

The next step is to determine your deductions. The tax law allows itemized deductions for state and local taxes, interest paid on mortgages, charitable contributions, medical expenses that exceed certain levels and a few other items. If you do not have large amounts of itemized deductions, you can take a standard deduction. After all the needed calculations, you arrive at your taxable income.

How Is Your Taxable Income Taxed?

There are different tax rate schedules depending on your filing status. Most taxpayers fall into the categories of filing single or married filing jointly. Here are the tax rate schedules for single and joint returns for 2015 and 2016.

Income Tax Rate Schedules for 2015

2015 Single Return Rate Schedule2015 Married Filing Jointly Rate Schedule
Taxable Income LevelsTax RateTaxable Income LevelsTax Rate
0 to $9,225 10% 0 to $18,450 10%
$9,226 to $37,450 15% $18,451 to $74,900 15%
$37,451 to $90,750 25% $74,901 to $151,200 25%
$90,751 to $189,300 28% $151,201 to $230,450 28%
$189,301 to $411,500 33% $230,451 to $411,500 33%
$411,501 to $413,200 35% $411,501 to $464,850 35%
More than $413,200 39.6% More than $464,850 39.6%

Income Tax Rate Schedules for 2016

2016 Single Return Rate Schedule2016 Married Filing Jointly Rate Schedule
Taxable Income LevelsTax RateTaxable Income LevelsTax Rate
0 to $9,275 10% 0 to $18,550 10%
$9,276 to $37,650 15% $18,551 to $75,300 15%
$37,651 to $91,150 25% $75,301 to $151,900 25%
$91,151 to $190,150 28% $151,901 to $231,450 28%
$190,151 to $413,350 33% $231,451 to $413,350 33%
$413,351 to $415,050 35% $413,351 to $466,950 35%
More than $415,050 39.6% More than $466,950 39.6%

For taxpayers in the 10% and 15% brackets, qualifying dividends and long-term capital gains (assets held for more than a year) will be taxed at 0%. For those in 25%, 28%, 33% and 35% tax brackets, the tax rate on dividends and long term capital gains is 15%. For those in the top 39.6% bracket, the tax rate is 20%.

Depending on your situation, there may also be a few credits to apply to reduce your taxes for things like foreign taxes and certain education expenses. The net result is your income tax liability for the year.

Paying Your Income Taxes

Your employer withholds federal income taxes from your paychecks and forwards those funds to the government. This is reflected in your Form W-2 along with your earnings and Social Security withholding. The amount of income tax they withhold is based on the Form W-4 on which you identify the number of exemptions you claim. The larger the number of exemptions, the less they withhold.

Some individuals also end up making quarterly estimated income tax payments if they suspect their withholding will not be sufficient. There can be interest and penalties if the total of your withholding and estimated payments are too little.

You then compare your income-tax liability with the total payments you have already made and the difference is what you owe or the amount of refund you should receive.

Other Issues

This article has only provided some of the very basics of our income tax laws. The alternative minimum tax, special distributions from retirement plans, stock options, changes in marital status are just a few of the hundreds, if not thousands, of other issues that can complicate your situation.

Each person's situation is different, the rules are complex and the consequences of not following the rules can be severe. Be sure you get the tax advice you want and need from a qualified professional.

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